Non-Governmental 457(b) Plans – Increased Deferral Opportunities for Key Employees of Nonprofit Organizations

Attracting and retaining key executives can be challenging for non-governmental tax-exempt organizations such as Internal Revenue Code (“Code”) section 501(c)(3) organizations, private universities, and certain healthcare organizations (“nonprofits”). Nonprofits are, in many cases, competing for the same talent as for-profit entities that can offer cash and equity compensation packages. However, in order to protect their tax-exempt status, nonprofits must comply with Internal Revenue Service rules requiring that compensation paid to their employees is reasonable and not excessive under the intermediate sanctions regime. In addition, they are subject to a 21% excise tax on compensation over $1 million paid to an employee or in which the employee becomes vested in the current year. These rules can put nonprofits at a disadvantage when trying to attract and retain key employees.

Non-governmental 457(b) Plans

One of the first steps (see note below) to make nonprofits’ compensation packages more attractive to potential executives is to implement a non-governmental Code section 457(b) plan (“section 457(b) plan”) to provide executives additional opportunities to defer current compensation. These plans are relatively easy to implement and, more importantly, are not subject to the onerous rules under Code section 409A. It permits eligible executives to defer additional compensation for retirement by contributing the maximum amount of $23,500 annually (2025 limit) to the plan in addition to their contributions to the nonprofit’s 403(b) or 401(k) plan. It is the ability to double up on retirement contributions that is the primary advantage of a section 457(b) Plan.

Some nonprofits chose to make matching contributions or bonus contributions to the section 457(b) plan. These amounts offset the executive annual deferral limitation, and they must be treated like any other salary deferral contribution subject to payroll tax, if fully vested when made.

Additional advantages of a section 457(b) plan are:

1. As noted above, the plan is not subject to the nonqualified deferred compensation rules under Code section 409A, which provides for restrictions on changing employee salary deferral contributions and distribution elections.
2. Hardship distributions are permitted for unforeseen emergencies.
3. Contributions made by employees who move from their resident state with an income tax to a state with no income tax following a termination from employment are not subject to income tax in their former state of residence, as long as installments are paid over a period of 10 years or more.
4. Participants may direct the investment of their accounts in a similar manner as done for section 401(k) or 403(b) plans.

Note: In addition to offering key executives a section 457(b) plan, many nonprofits offer a section 457(f) plan, which is outside the scope of this article, but is subject to the much more complex rules under Code sections 409A and 457(f). In exchange for the complexity, 457(f) plans do not have contribution limitations other than the general restrictions on nonprofits’ compensation noted above.

Eligibility

To avoid ERISA’s funding, disclosure, and Form 5500 reporting requirements, a section 457(b) plan must be a “top-hat” plan, which is:

1. an unfunded arrangement – meaning that plan assets are not held in trust for employees, but remain the property of the nonprofit and available to its general creditors; and
2. that is limited to a “select group of management or highly compensated employees.”

Unfortunately, the U.S. Department of Labor has never defined what constitutes a select group of management or highly compensated employees; however, the courts and the Department of Labor have historically considered the following in making their determination:

1. The number of employees eligible to participate in the section 457(b) plan vs. the nonprofit’s total number of employees;
2. The average salaries of members of the eligible group vs. those of other employees or other management/highly compensated employees; and
3. The ability of members of the eligible group to negotiate their own salary or compensation packages.

Contribution Limits

Annual contributions to a section 457(b) plan cannot exceed the lesser of:

1. 100% of the participant’s compensation; or
2. The section 457(b) contribution limit for the year.

The annual limit applies to both employee deferrals and any vested employer contributions for the employee’s calendar year. Accordingly, as with 401(k) plans and 403(b) plans the employee will not be able to make contributions of more than $23,500 no matter how many section 457(b) plans an employee may participate in during the calendar year. The amounts contributed to an employee’s section 457(b) plan account will not, however, affect the amounts an employee may contribute to a nonprofit’s section 401(k) or 403(b) plan.

Participants in section 457(b) plans are not eligible to make over age 50 catch-up contributions. They may, however, be eligible to make special catch-up contributions for the three years before they reach normal retirement age under the plan. The special catch-up limit is the lesser of:

1. Two times the applicable dollar limit ($47,000 in 2025); or
2. The applicable dollar limit plus the sum of unused deferrals in prior years (only if the deferrals made were less than the applicable deferral limits).

FICA Recognition

Employee deferrals to a section 457(b) plan and/or any vested employer contributions are subject to Social Security and Medicare (“FICA”) tax withholding when contributed to the plan and reportable on the employee’s Form W-2 for the year of contribution. If unvested employer contributions are made, they will be included in the employee’s income for FICA purposes in the year of vesting.

Distribution Rules

Section 457(b) plans are considered a nonqualified deferred compensation plan for purposes of plan distributions meaning that amounts deferred under the plan are included in a participant’s taxable income when paid or made available to the participant.

Section 457(b) plan documents typically provide that amounts are considered to be made available on the earliest date distributions are permitted to begin under the plan’s terms following a participant’s termination from employment, but not later than the date when required minimum distributions under the plan must begin. Distributions from the plan are reportable on a Form W-2 for the year of distribution (even if the employee terminated employment in an earlier year) and are subject to federal, state, and local income tax withholding, as applicable, but not FICA withholding, assuming FICA was withheld when the deferred amounts became vested under the plan.

Further, amounts distributed from a section 457(b) plan are not eligible for rollover to an IRA, or an employer sponsored 401(k), 403(b), or governmental 457(b) plan. If permitted under the section 457(b) plan of a new employer, the distribution from the old plan to the new plan may be rolled over provided it is made as a direct trustee-to-trustee transfer.

Conclusion

Nongovernmental Code section 457(b) plans are a simple way for nonprofits to offer key employees a way to defer compensation in excess of the limits under their organizations’ section 403(b) or 401(k) plan. For larger nonprofits, a section 457(b) plan is frequently offered in conjunction with an individually tailored, separate Code section 457(f) plan to attract and retain key employees.